How To Invest

WARNING: For investors in a Deutsche Bank-sponsored ETF or ETN (or even if you’re not)

It’s a matter of time before someone gets hurt in the slow-motion collapse of Deutsche Bank, Europe’s largest bank. You need to be sure – even if you’re far away from Germany – that your money isn’t collateral damage. And if you own ETFs or ETNs (which trade in a similar way but are very different) that are issued by Deutsche Bank, you’ll want to pay particularly close attention.

And it’s not just Deutsche Bank. If you own an ETF or an ETN, there’s a good chance that you’re taking counterparty risk (which I’ll explain in a minute) that you’re not even aware of.

Last month, I suggested three telltale signs that a bank – in this case, Deutsche Bank – is in serious trouble. Since then, Deutsche Bank has unfortunately been acing all three of these tests with flying colours. Senior government ministers and the bank’s head can’t stop telling the market how Deutsche Bank is stronger than a bull, flies higher than an eagle, and has the wisdom of an owl. Most telling is the continued collapse of the bank’s share price, which is down 46% since the start of the year – and down 11% over the past month alone.

Look at your ETFs and ETNs

Problems at Deutsche Bank, if (and when) they intensify, could hit home for investors all over the world in many ways. As the global economic crisis of 2008-2009 showed, financial contagion – when markets start to fall – lead to almost all markets to be highly correlated.

One way that your portfolio could be hurt that might not have thought of: Deutsche Bank sponsors (manages) more than 200 ETFs and ETNs listed on 10 stock exchanges globally, with more than $40 billion in total assets. (We’ve compiled a list of some of these here {this is a link to download an Excel file})

A few of DBs largest ETNs traded in New York, in terms of assets include the $349 million Deutsche Bank FI Enhanced Global HY ETN (FIEG), the $146 million DB Gold Double Long ETN (DGP) and the $66 million DB Crude Oil Double Short ETN (DTO). Also, Deutsche Bank is the largest ETF sponsor in Singapore and Hong Kong, in terms of total product offerings, with 45 ETFs listed on the STI and 35 on the Hang Seng.
What happens to the Deutsche Bank-sponsored ETF or ETN if the German bank collapses, and has to be bailed out?

To answer that, it’s crucial to understand the differences between an Exchange Traded Fund (ETF), a synthetic ETF, and an Exchange Traded Note (ETN).

The term “ETF” is broadly used to describe exchange-traded investment funds. But there are actually two main types of these funds: Exchange Traded Funds and Exchange Traded Notes.

When you buy an ETF, you receive an ownership stake in a pooled investment, which is structured as an independent entity. Most ETFs are “physical” ETFs. These track a target index by holding all, or a representative sample, of the underlying securities that make up the index. That means that you own a tiny stake in a company that’s invested in a number of different shares. For example, if you invest in an S&P 500 ETF, you own a bit of each of the 500 securities represented in the S&P 500 Index, or some subset of them.

ETFs are independent of the sponsor, issuer, and manager. In this case, if the ETF provider were to go bankrupt or shut down the ETF, the shareholder would usually receive cash for the market value of the basket of securities. With physical ETFs, there is virtually no default risk, as the investor would be able to take ownership of underlying assets.

Read the fine print of ETNs and synthetic ETFs

ETNs and synthetic ETFs are a different story. ETNs and synthetic ETFs typically hold no actual securities, but instead “engineer” the returns of a specific index.

Instead of being an independent pool of securities, an ETN is a bond issued by a financial institution. That company promises to pay ETN holders the return on some index and return the principal of the investment at maturity. In essence, an ETN investor lends money to the issuer, who promises to pay the return on an index. ETNs own nothing, are not collateralised, and carry the credit risk of the issuing firm. If something happens to that company (such as bankruptcy), ETN holders could be left with little or nothing.

Many ETNs track commodity indices, since replicating a commodity index’s returns is easier and more profitable than physically managing commodity ownership for every investor.

One of the largest ETNs based on assets is Barclay’s iPath Dow Jones Commodity Index (DJP). The index tracks energy, grains, industrial metals, precious metals, livestock and other commodities. If you buy DJP, you may think you therefore own commodities, but you don’t. An investor in DJP owns only a promise from Barclays to pay an investor the theoretical allocation of the commodity index. If the ETN provider should go bankrupt, the investor will not receive his or her investment back. (The largest ETN is the JP Morgan Alerian MLP Index ETN. Similarly, investors in this ETN don’t own any actual master limited partnerships.)”

Synthetic ETFs are similar to physical ETFs with one important difference: Instead of holding the underlying securities of an index, the ETF investor owns “swaps” and other collateral which are used to replicate the holdings. A swap is a contract with another financial firm or “counterparty” that promises to pay an index’s return to the fund. Using derivatives – rather than actually buying the underlying asset – reduces the fund’s costs, and those savings are passed on to investors.

While there are regulations that may limit an ETF’s exposure to any one counterparty, the fact remains, if a counterparty should become unable to pay, the investor in a synthetic ETF could lose money.

And in the case of at least some Deutsche Bank synthetic ETFs, Deutsche Bank is the sole counterparty. For some, it may be one of several counterparties

Below is an excerpt from Deutsche Bank’s ETF website describing the Singapore-based Euro Stoxx 50 UCIYS ETFwith S$7.45 billion in assets:

The ETFs may enter in over-the-counter derivative transactions such as swap(s) which will expose the relevant ETF to the credit risk of the counterparties to such transactions. The NAV of the relevant ETF may have a high volatility due to its investment objectives, policies or portfolio management techniques. Please refer to the Singapore Prospectus for more details. The swap counterparty is currently Deutsche Bank AG. This may give rise to potential conflicts of interest. Information on the creditworthiness of Deutsche Bank AG can be found at

The ETF risk you haven’t thought about

The chief risk of synthetic ETFs is that a counterparty might fail. Essentially, ETN and synthetic ETF investors trust that a bank – that is, the bank that agreed to pay the fund the return of a specific asset or index – will follow through on its obligation to pay the agreed-upon index return. If it doesn’t, investors in the ETN or synthetic ETF could lose most, if not all, of their investment.
This happened in September 2008, when three ETNs sponsored by Lehman Brothers – the US broker that precipitated the 2008 financial meltdown – halted trading when Lehman collapsed. The ETNs were relatively small, with only a few tens of millions of dollars in assets. But investors who held these were treated like any other creditor in Lehman, and were paid back only about 9 cents for every dollar invested.

An investor owning an ETN or a synthetic ETF sponsored by Deutsche Bank, where Deutsche Bank is also the counterparty, is in essence lending their money to the German bank, and bears counterparty risk should the sponsor go bankrupt.

Deutsche Bank is far too big to allowed to collapse. Millions of people hold their savings with Europe’s biggest bank. However, this doesn’t protect investors in Deutsche Bank shares, or investors who have counterparty risk with Deutsche Bank – which includes shareholders of ETNs or synthetic ETFs that are sponsored by Deutsche Bank.

ETFs are not the simple “one decision” investments they are often made out to be. These funds vary considerably in complexity and risk. It would make sense for anyone holding “X-trackers” – or any other ETF or ETN product related to Deutsche Bank – to read that fund’s website thoroughly, including its prospectus. Here we’ve compiled a list (click to download an Excel file) of Deutsche Bank ETFs and ETNs that are traded in Singapore, Hong Kong, London and New York, along with whether these funds use swaps or derivatives (that is, if they’re “synthetic”). Investors in some vehicles in Singapore and other markets are afforded some protections, but it’s smart to check anyway.

You can also check yourself on Deutsche Bank’s ETF website: Choose the country of interest on the left, then links to specific funds can be found on the bottom right. Under ETF details, check “Index Replication Technique” to see if the ETF uses Direct Replication (that is, if it’s a “physical” ETF) or Synthetic Replication (synthetic ETF). As discussed, Direct Replication has much less risk. Again, read the prospectus listed under “Documents and Downloads.”

It’s impossible to know what might happen if Deutsche Bank’s problems continue to mount. But with so many alternatives available in the universe of ETF products, some investors might prefer to sell any Deutsche Bank-sponsored fund that uses derivatives, where Deutsche Bank might be a counterparty. (Many other non-Deutsche Bank ETFs and ETNs may use Deutsche Bank as a counterparty.)

Kim Iskyan

Kim Iskyan is a former research director for an emerging market investment bank and hedge fund manager, and has spent the past 25 years exploring and analyzing global markets. Kim has been quoted in the Economist, The New York Times, the Wall Street Journal, Barron’s, and Bloomberg. He's appeared on Fox Business News, China Central Television, Bloomberg TV, and elsewhere. Kim is also the founder of Truewealth Publishing where he writes and shares his investment insights regularly.

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